Imagine that you never heard about options. Assume that you fancy yourself to be a good stock picker and market timer. You often repeat a trading slogan: “Have a hunch? Bet a bunch.” The results are pretty straightforward. If your hunch was correct, you get to sell your stock at a profit. If incorrect, you usually take a loss, but may break even.
That was the life of an equity trader in the good old days (before 1973 when listed options began trading).
The Options World
Option traders can adopt the same strategy and buy a bunch of calls or puts when they want to play a hunch. The results are often as expected: stock moves in the right direction, earn a bunch. Stock does not do as expected; lose a bunch.
But that is so inefficient and (in my opinion) a silly way to trade options. One of the fascinating things about trading hedged option positions (spreads) is that you can make money, even when you are wrong.
— XYZ is $58 per share.
–You are bullish and expect the stock to move past $60 over the next month (two months, tops).
–Instead of buying calls, consider selling a put spread.
–Sell the 2-month 50/55 put spread, collecting an $80 premium.
–If the stock moves higher, the spread expires worthless and you keep the whole $80
–If the stock remains stuck near $58, you win again as the options expire worthless.
–If the stock price moves lower (not what you expected to happen), you are a winner if the decline is not too large.
Imagine earning a profit when your prediction is incorrect! It is a wonderful feeling to know that you do not have to predict the future to earn money.
Of course this trading style (credit spreads) has drawbacks. Profits are limited to the premium collected. If the stock undergoes a good-sized rally, that will be a disappointment. All traders like the opportunity to earn a large profit. To offset this negative feature (limited profits), the put spread seller earns a profit far more often than the stock or call buyer.
I love the trade-off: Limited profits in return for more frequent gains. The other great advantage of selling the put spread is that losses are limited. This is not something that occurs to bullish traders, but this $58 stock may be trading below $50 tomorrow. Spread traders are never exposed to unlimited losses. If your trading history has always consisted of buying options, consider trading spreads.
Let me repeat that: It is easier to find a stock that will not decline than it is to find a stock whose price will increase. In traditional investing, the traditional path to profits is to buy something that increases in value. When selling put spreads, a rally is appreciated, but it is not needed to earn a profit. This is an eye-opener for the novice trader.